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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Capital Structure

Under the Modigliani-Miller (MM) proposition in a world without taxes and with perfect markets, an unlevered firm U has a value of Rs 50 crore. An otherwise identical firm L has Rs 20 crore of debt in its capital structure. What is the market value of the equity of firm L?

The equity of firm L is worth Rs 30 crore. Under MM without taxes, firm value is unaffected by leverage, so L is worth Rs 50 crore like U. Subtracting the Rs 20 crore of debt leaves Rs 30 crore as the market value of equity.

  1. ARs 50 crore
  2. BRs 20 crore
  3. CRs 30 croreCorrect
  4. DRs 70 crore

Explanation

With no taxes, MM proposition I states that the value of a firm is independent of its capital structure. Firm L is therefore also worth Rs 50 crore. Equity value is total value less debt, which is 50 - 20 = Rs 30 crore. Rs 70 crore wrongly adds debt to firm value.

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